Tax Controversy Group > Tax Litigation > Making the Most of Lesser Known Tax Benefits (and Avoiding Pitfalls) Associated with Revitalization Projects: I.R.C. § 170 and a Discussion on Façade Easements and Deconstruction

Making the Most of Lesser Known Tax Benefits (and Avoiding Pitfalls) Associated with Revitalization Projects: I.R.C. § 170 and a Discussion on Façade Easements and Deconstruction

In recent years, there has been a shift back towards “city life” and many efforts have been made to spur revitalization, both commercial and residential. Those looking to capitalize on revitalization opportunities should be mindful of tax incentives offered by state and local governments, such as the Enterprise Zone Property Tax Credit, Historic Restoration and Rehabilitation Property Tax Credit, just to name a few. Even if those incentives are not available, individuals and businesses may be able to benefit from other tax opportunities, through the charitable contribution of façade easements (and other preservation easements) and “deconstruction;” however, these opportunities should be carefully considered as they will likely be subject to intense scrutiny by the Internal Revenue Service. Procedural foot-faults can lead to substantial assessments of tax and penalties.

What is a “Façade Easement”?

This is a type of preservation easement whereby a property owner conveys certain rights that preserve the historical nature of the façade of a building in perpetuity. Pursuant to I.R.C. § 170(h), the transfer of a façade easement on a “certified historic structure” may qualify for a deduction as a charitable contribution. In other words, if a developer purchases a property that is listed in the National Register or is located in a registered historic district certified by the Secretary of Interior as being of historic significance, it may be able to reap significant tax benefits in the redevelopment process if it agrees to preserve the façade by transferring rights to certain types of charitable organizations. In determining whether redevelopment is financially feasible, this tax provision may play a large role in construction projects involving certain historical buildings.

While the benefits of these deductions can be significant and may even dictate financial viability, they can often raise red flags with the Internal Revenue Service and the deductions must meet stringent procedural requirements. As recently as 2011, a report by the Washington Post indicated that 70 percent of claims for deductions related to façade easements had been denied and taxpayers had been assessed with hundreds of thousands in taxes and penalties, in the local area alone. Façade easements have also been scrutinized by the Senate Finance Committee and recently appeared on the Internal Revenue Service’s “Dirty Dozen” list of tax scams. While the Internal Revenue Service acknowledges that Congress intended to allow certain types of donations in order to preserve the nation’s heritage, the Service continues to bemoan the pattern of abuse where “taxpayers, often encouraged by promoters and armed with questionable appraisals, take inappropriately large deductions for easements.” With respect to façade easements in particular, the Service notes that “if the façade was already subject to restrictions under local zoning ordinances, the taxpayers may, in fact, be giving up nothing or very little. A taxpayer cannot give up a right that he or she does not have.”

As any problems regarding the deduction can cause a potentially profitable project to turn into a financial loser, developers should be mindful of the requirements on the front-end in order to prepare for a likely future challenge and preserve the potentially substantial tax benefit. In order to qualify for a deduction under I.R.C. § 170, the following non-exhaustive requirements must be satisfied for each façade easement:

Must be on a “certified historic structure”

Must meet technical requirements, which include restrictions preserving the entire exterior, providing visual access to the easement, and prohibiting changes inconsistent with historical character

Must be contributed to a “qualified organization,” which is committed to conservation and enforcing the easement, in writing and in perpetuity

Must be substantiated by a “qualified appraisal” (contemporaneous written appraisal of the value contributed, authored by a professional)

If the claimed contribution deduction exceeds $10,000, must be accompanied by a $500 filing fee

Each of these requirements contains further technical clarifications which requires consideration before making a decision to pursue this deduction and its tax benefits.

While those claiming the contribution deduction may have the best intentions, the Service often attacks these deductions for failure to meet technical requirements and for perceived valuation errors. See, e.g., Dunlap v. Commissioner, T.C. Memo 2012-126 (disallowing entire charitable contribution deduction of façade easement in the amount of $8,171,000 based on lack of substantiation); Scheidelman v. Commissioner, 682 F.3d 189 (2d Cir. 2012) (reversing decision of Tax Court, which found that appraisal insufficiently explained valuation of façade easement contribution); Kaufman v. Commissioner, T.C. Memo 2014-52 (Tax Court denied deduction for contribution of façade easement and sustained penalties for valuation misstatement). And the Internal Revenue Service has begun to challenge such easements on the basis that they are no more restrictive than the general regulations of a neighborhood and, therefore, cannot have any value. See, e.g., Scheidelman, 755 F.3d 148 (2d Cir. 2014) (finding that “easement does not add any new restrictions…because the historical preservation laws of the City of New York already require a specific historic review of any proposed changes to the exterior…”).

Therefore, if a deduction for a façade easement is sought, it is more important than ever that, from the outset, developers engage appraisers and tax counsel knowledgeable in local zoning and building regulations and the requirements of I.R.C. § 170 and its accompanying guidance. If these technical requirements are not met, the Service can, and likely will, assess a variety of penalties, including the accuracy-related penalty, gross valuation misstatement penalty, and fraud penalty, amongst others. The combination of taxes and penalties can quickly turn a financial boon into a boondoggle.

What is “Deconstruction”?

In its most basic form, deconstruction is the professional dismantling and recycling of valuable building materials found in existing buildings. This process can involve the donation of:

This niche industry has grown precipitously in the past decade as a result of several factors, has provided numerous jobs to individuals in economically-deprived neighborhoods, and has helped revitalize these communities. Some of these factors include an older housing stock, increased severity of environmental laws raising demolition costs, and an increase in overall environmental awareness. There are a growing number of organizations in the region that offer deconstruction services. While deconstruction may not be suitable to all redevelopment projects, due to the increased base cost of deconstruction versus demolition and potential time constraints, certain redevelopment of historical structures may be able to benefit from this technique. Further, developers can benefit from reduced waste management costs, landfill disposal costs, and if certain materials are not contributed to a charity, a future low-cost source of materials for other projects.

While developers may not have the ability or expertise to effectively harvest value from these existing fixtures, deconstruction can lead to substantial tax savings on certain projects and can be marketed as part of a project’s environmental-friendliness. As with façade easements, the ability to claim tax benefits from deconstruction is based on I.R.C. § 170. While the requirements to claim deductions for deconstruction-related contributions are somewhat less stringent than for façade easements, the donation must still meet all of the following:

Must be contributed to a “qualified organization”

Must be substantiated by a “qualified appraisal” (contemporaneous written appraisal of the value contributed, authored by a professional)

If the claimed contribution deduction exceeds $10,000, must be accompanied by a $500 filing fee

This means that, if deconstruction is pursued, a developer should consider the costs associated with a professional appraisal, maintaining required substantiation, and paying a filing fee. Environmental impacts aside, if the materials being donated are not of significant value, the value of the deduction may not justify this method from a financial standpoint. Developers should also ensure that the donee is an organization recognized by the Internal Revenue Service to receive used building materials; otherwise, the deduction could be disallowed.

While deductions for deconstruction efforts have been subject to less challenges by the Internal Revenue Service than façade easements, developers should be mindful of potential legal pitfalls and that somewhat similar techniques have been disallowed. See, e.g., Patel v. Commissioner, 138 T.C. No. 23 (June 27, 2012) (donation of house to fire department for conducting training exercises did not allow taxpayers to deduct value of house as charitable contribution); Scharf v. Commissioner, T.C. Memo 1973-265 (also involving donation to fire department for controlled burning exercises). Furthermore, it is important to note that the deductibility of any deconstruction is based upon the value of the items contributed, not the value of the property as a whole.

These descriptions are provided for informational purposes only. If I.R.C. § 170 may have any impact on a prior or prospective rehabilitation or revitalization project, you should contact a tax attorney. For a free consultation, please contact Brandon Mourges at 410.951.1149 orbmourges@rosenbergmartin.com.